Share Slump Tests Citi Limits

What happens next for CitigroupC-0.71% will have ramifications for the global financial system.

The last acts of the current U.S. administration, which already has spent billions of dollars trying to contain the financial crisis, could prove pivotal.

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Following steep drops all week, Citi's shares shed another 26% Thursday, even after Prince Alwaleed bin Talal, a large and longtime shareholder, said he plans to increase his stake in the bank. Big stock-price declines at other banks -- J.P. Morgan Chase fell 18% Thursday -- are likely to be equally unnerving for the authorities.

The market appears to be in a game of chicken with the government over Citi. At issue: whether government guarantees on bank debt and the recent preferred-equity injections from the Treasury will be sufficient to get banks through the crisis.

Citi says it is adequately capitalized and has sufficient liquidity. But if the share-price rout continues, one option for the government is to plow extra capital into the banks in return for more preferred shares. This time, the government could even sweeten the terms, perhaps requiring a lower dividend than the 5% on its existing preferreds -- in an explicit attempt to reverse the share-price falls.

The political risk of giving banks basically free money is huge. And even that mightn't do the trick. Paul Miller, bank analyst at FBR Capital Markets, notes preferreds don't reduce the amount of leverage piled on top of common shareholders. And right now, Citi's assets exceed its tangible net worth -- shareholders' equity minus intangible assets and preferreds -- by 56 times, compared with 49 times for Bank of America.

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Associated Press

The only way to get that ratio down is to slash assets -- almost impossible right now -- or issue a large amount of common stock.

And that is the dilemma for the government. Citigroup's market value is $26 billion. If the government wanted to inject another, say, $25 billion through common stock it would end up controlling the bank. And after its experience with American International Group -- the insurer has consumed more than $87.4 billion of taxpayer funds -- the government is going to think very hard about which firms it controls.

The government and Citi might yet sweat this out. The market may recover its poise once it realizes the government is likely to strengthen the bank debt guarantees -- a move signaled Thursday by the Federal Deposit Insurance Corp.

This could help boost confidence in Citi, where one big worry is whether the market will refinance the bank's debt as it comes due. According to J.P. Morgan analysts, Citi has $54.6 billion of corporate debt maturing through June 30 of next year, more than other large U.S. banks.

But there is a real risk Citi's situation worsens and becomes contagious. The government needs to be ready, if needed, to quarantine it.

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